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Fool on Call: Netflix Punished for Planning Ahead

Offer me solutions,Offer me alternatives,And I decline!-- "It's the End of the World As We Know It," by R.E.M.

Sometimes the earnings release doesn't quite relate the entire story. Judging by the market reaction to last week's report from online video maven Netflix (NASDAQ:NFLX), not many investors cared to check in on the analyst call, but collectively dumped the stock price on what looked like seriously pessimistic subscriber addition guidance. Your Fool on call is here to right that misperception. In short, this is not the end of the world, but we are closing in on the end of National Poetry Month. Darn it.

Dig inThe obvious reason to dump on this stock is there in the guidance section of the earnings report, in stark black and white: "Ending subscribers of 7.3 million to 7.8 million, down from 8.0 million to 8.4 million." It's so easy to take that as evidence that Blockbuster (NYSE:BBI) is eating Netflix' lunch, burning down the kitchen, and plowing salt into the fields. And in the conference call, CEO Reed Hastings concedes that the competition is coming on strong.

"Our thesis that most subscribers would choose Netflix seems open to question," Hastings said. But then he explained why Netflix isn't doing anything different in the face of this new development: "If we thought the proposition of giving away one free store rental for every online rental, while maintaining price parity, was an economically viable proposition, we would be concerned about our long-term leadership and would take appropriate steps. But we're confident Blockbuster's online offering is not economically viable at current prices."

That's a strong statement to make, but also a fairly obvious conclusion to reach. After all, Netflix has been working on its business model for some nine years now, with input from a former U.S. postmaster general and a renowned, near-fanatical attention to detail. This is a very efficient movie-mailing operation, with a significant head start on Blockbuster's alternative.

Add in the in-store video exchange aspect of Blockbuster Total Access -- at once the program's biggest selling point and greatest weakness -- and the added overhead, followed by cannibalized store rentals, works out to an operational nightmare.

"So to us, it is not a question if Blockbuster will raise their online prices," Hastings continued, "but only when and how much. And when they do, it will reset the competitive calculus as well as increase their profits."

Based on our assumptions ...The forward guidance comes from a set of worst-case assumptions. "Despite the likelihood of a Blockbuster price hike at some point, we of course have no sense of when or how large it might be, so when updating guidance for the year, we have to assume there is no price hike this year. Given that, we are maintaining our EPS guidance for approximately $0.80 for the year, and cutting our ending subscriber guidance to 7.3 million to 7.8 million. If there is a positive change in the pricing environment, we would expect to upwardly revise our subscriber guidance after that."

The stated long-term customer growth goals at Netflix will slip out of reach under these circumstances, but that's a hit Hastings is willing to take. So, Netflix isn't going Cassandra on us with that lowered subscriber outlook -- it's simply a management team planning for the worst even when they expect something much better.

Could Netflix afford to lower prices a bit in a bid to take back some lost market share? Absolutely. It's a net profitable company despite heavy marketing expenses, and the balance sheet is very strong. So strong, in fact, that the company just started its first-ever share buyback program with a $100 million budget.

To me, the lack of desperation here shows that management is truly thinking about the long-term good of the company and not managing to meet short-term expectations. I also happen to think that Hastings is exactly right. It's hard to see how such an aggressive play for subscriber growth could translate into a tenable, long-term success, especially when Blockbuster's balance sheet is shaky at best, including a negative net tangible assets balance.

Anecdotal evidenceLast month, my family was on both the usual Netflix plan and a Total Access free trial, in preparation for this round of earnings report. I haven't watched that many movies a week since college, when my professor assigned a list of 40 sci-fi flicks for a six-week class, but I digress. Let me tell you what I think about Total Access as a business proposition, based on direct customer experience.

At first, it was really cool to stop by the store and grab some instant gratification off the shelves, for free. But the novelty wore off quickly.

I found myself longing for a copy of my viewing queue every time I browsed the store.

The stream of interesting new releases can't keep up with the rental throughput of a three-at-a-time Total Access plan, which tends to work out to about six movies a week. And, of course, since Blockbuster did away with late fees (participating locations only, your store might not subject itself to this torture), you can keep new releases at home for over a week with no consequences -- so those shelves are often stripped down to bare particle boards.

And so, at the end of the trial period, my wife and I had essentially run out of in-store movies we wanted to see. Did you know that the average Blockbuster location stocks only 6,000 or so different titles at any given time? Both of the by-mail services boast more than 10 times that many movies.

I wouldn't be surprised, in other words, to see a substantial increase in customer churn when Blockbuster reports its numbers next week. There isn't enough there to hold customer interest for very long, and many of the free trials that started over the holidays should fizzle out into a flood of cancellations sooner rather than later. Of course, given that each faithful customer ends up costing Blockbuster money, that company's management probably will breathe a secret sigh of relief at every canceled account.

Foolish finaleThere are more nuggets of market insight in that earnings call, so it's highly recommended listening for anyone following the consumer entertainment markets. But the big takeaway here is that Netflix is being punished in the open market for showing financial restraint, making this just about the perfect time to look into the stock. It's a longtime Motley Fool Stock Advisor recommendation, and a free 30-day trial will show you why David Gardner continues to believe in a stock he first picked over three years ago.

Fool contributor Anders Bylund is a Netflix shareholder but holds no other position in any of the companies discussed here. You can check out Anders' holdings if you like, and Foolish disclosure is always entertaining.